Inflation threat looms

Flexible exchange rate may fuel imported inflation that has been on rise since March


Dr Fahd Rehman August 16, 2021
The government is currently in negotiations with the IMF for the next loan tranche of $1 billion. PHOTO: FILE

LAHORE:

Pakistan’s economy is gradually moving in a recovery phase. The recovery is accompanied by supply bottlenecks, which have started to create upward pressure on prices. The recurrent Covid waves are creating hurdles in the smooth supply of raw material, capital goods and even finished products. These obstacles have also increased shipping and freight costs, which used to be negligible in the pre-Covid era. The disruptions to supply chains have increased transaction cost.

In order to meet the emerging challenge, the supply chains need to be readjusted and reconfigured, which will take some time. Large multinational companies (MNCs) have started to take into account geographical proximity in dealing with supply chain issues. Some of them are rethinking to develop relationship with suppliers in close proximity. All these developments contribute to the high cost of finished products. The government spent around Rs680 billion under the Public Sector Development Programme (PSDP) in FY21.

News reports highlight that funds were diverted away from development projects to meet commitments of line agencies. An important project related to Covid19, ie WASH, could not get started. Covid-19 brought many changes in businesses and even enhanced economic uncertainty. Many old businesses got affected and vanished. In the midst of high uncertainty, investors park their capital in real estate. Businessmen put their money in the real estate to diversify their portfolios, while others used this to earn their living.

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A large chunk of people started to pour money into this business as a saving option. In addition, the government brought an amnesty scheme for the construction sector in 2020, provided tax exemptions and even froze the valuation tables. All of these factors contributed to the real estate bonanza. The real estate boom supports the current recovery. On the monetary front, the State Bank of Pakistan (SBP) adopted an accommodating approach and reduced the policy rate to 7% in June 2020. Since then, the policy rate has been kept constant to propel the recovery.

In addition, the Temporary Economic Refinance Facility (TERF) provided a great opportunity to large corporates either to get financing or expand their business. These steps played a significant role in reviving the industrial activity in the country. Similarly, exporters got incentives, which enabled them to show improved performance. This time around the SBP has taken a flexible exchange rate path. It is usually believed that the flexible exchange rate allows the movement of currency based on demand and supply of foreign exchange.

If there is capital inflow, the rupee will appreciate. The rupee has already got that appreciation and reached Rs152 in March 2021. On the contrary, the outflow of capital will result in depreciation of the rupee, which is happening at the moment. Normally, the rupee gets under pressure owing to external debt servicing and a rising import bill. When the rupee comes under pressure, the SBP may intervene in the forex market by using the foreign exchange reserves.

However, the SBP is focusing on maintaining the reserves and allowing the rupee to depreciate. The rationale is that the rupee will get its true value, which is reflected through the real effective exchange rate and this exchange rate will maintain export competitiveness. In the last recovery phase of 2015- 17, the previous government used a fixed exchange rate to pump up the economy. The SBP used to change the policy rate and utilised the foreign currency reserves to keep the wheels of economy moving.

In short, the current approach of flexible exchange rate is different from the earlier ones. This approach will fuel imported inflation, which has been on the rise since March 2021. Let’s see how the policymakers respond to the challenge of inflation in the coming months.

THE WRITER IS THE ASSISTANT PROFESSOR OF ECONOMICS AT SDSB, LAHORE UNIVERSITY OF MANAGEMENT SCIENCES (LUMS)

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